What do I do with excess capital? Pay off the mortgage or invest in Mr. Market. I have heard many arguments to this question. Why pay on a 5% (or less) loan when I am making 10+ % in this bull market? Seems like the choice should be clear, but its not! When I look amortization schedules, I notice the interest is front-loaded in the loans, meaning the first few years it seems like all of my payments are pure interest....
If my payment is 550 for the month and 400 went to cover the interest, then that 5% loan I signed up for seems to me like a 72% interest loan...
When I was driving home from work, I listened to John Pollock on the radio (financial tax strategy specialist). He discussed a concept called "Cash Flow Equivalent Return," which I thought was brilliant. To put this idea in words, he made an example:
"Let’s imagine a mortgage with $100,000 in principal, and a $1000 monthly
payment. If I won $100,000 in the lottery, and paid off the house, I’d
save $1000 each month. The big question is this – if I put that
$100,000 in the market instead of paying off the mortgage, what kind of
rate of return would I need in order to get that same $1000 per month
benefit in my cash flow? Said another way, what’s the Cash Flow
Equivalent Return that I need to break even? I’d need to make $12,000 a
year from my $100,000, a 12% return."
The example above highlights the importance of paying off debts, which is something I have been working on diligently. In my personal case, my rental income will more than cover my families expenses if I was debt free, so this also catalyzes my debt repayment efforts!